Economics

Central banking

Doomed to fail?

MANY agree that central banks need to rethink their objectives and tools in light of the crisis. Few, however, agree on what those new objectives should be or what the available tools actually are. (Those interested in some of the latest research should read this.) While some ideas have more merit than others, I am sceptical that any central bank is capable of fulfilling its objectives over any meaningful length of time because, as the late Hyman Minsky explained, lower observed macroeconomic volatility in the short term encourages greater financial risk-taking. Thus, the longer the perceived good times last, the more fragile the economy becomes. (An earlier post explains how this works in the narrower context of bank risk models.) This has few immediate implications, but reformers should be profoundly sceptical that they have found the fool-proof rule for optimal central banking.

Some might say that Mr Minsky’s insight is irrelevant because we have the ability to quickly deal with downturns that occur when the private sector is highly indebted. Unfortunately, the actual track record suggests otherwise—even though we have a pretty good idea of what to do in these situations. (The optimal policy mix seems to include writedowns, increased public borrowing to offset declining private borrowing, and perhaps some sovereign debt monetisation by the central bank.) History overwhelmingly demonstrates that the will to do all that is necessary does not develop until after many years of pain. That helps explain the empirical evidence collected by Oscar Jorda, Moritz Schularick, and Alan Taylor, who found that recessions occuring after periods of rapid credit growth were consistently worse than other recessions:

One of the important implications of that chart is that high levels of private debt make it harder to restore growth even in the absence of an acute crisis. Perhaps that is why the developed world’s central banks have had to keep short-term rates low for longer in the three most recent cycles (1989-1994, 2001-2004, and 2007-present) than in previous ones. Even then, the past three recoveries have been markedly weaker than those that came before. Combined with the reality that policy responses to debt crises are almost always suboptimal, it seems reasonable to try to think of ways to prevent unsustainable levels of borrowing.

One challenge is determining what counts as “sustainable”. There is no one right answer here, but a recent paper from Claudio Borio, Piti Disyatat, and Mikael Juselius of the Bank for International Settlements is a decent start. Building on empirical research from a range of scholars, including Messrs Jorda, Schularick, and Taylor, they try to improve the concept of economic “potential” by considering how spending is financed and whether those financial relationships are sustainable. In other words, they attempt to incorporate some of Mr Minsky’s insights into macroeconomics, which traditionally ignored the existence of a for-profit financial sector:

A combination of limitations in incentives and in perceptions of value and risks can drive self-reinforcing but unstable spirals between financing constraints, the valuation of assets and economic activity. In all this, credit plays a key role. Credit is the oil that makes the economic machine run more smoothly. But unless it is sufficiently well anchored, credit creation can also support unsustainable paths...Like a piece of rubber that stretches too far and eventually snaps, the self-reinforcing interaction between credit creation, asset prices and the real economy can lead to a build-up of financial imbalances that eventually derails economic activity. At the same time, financial burdens can prevent the economy from running at full capacity—so called “financial headwinds”. Thus, it is important to take into account the extent to which financial conditions facilitate or constrain economic activity when formulating judgements about the sustainable level of economic activity.

This alternative methodology is far from perfect, which the authors readily acknowledge. But it seems like a step in the right direction. One helpful result is this chart, which compares other measures of the “output gap” against their adjusted measure (the green line):

Had policymakers responded differently, it is possible that pre-crisis growth in America, Britain, and Spain might have ended up looking more sustainable in retrospect. But, as noted above, policymakers almost always disappoint. They are human, after all. Depressingly, Carmen Reinhart and Kenneth Rogoff have shown that America’s post-crisis performance, while bad in an absolute sense, has actually been relatively good compared with the broader historical record. That tells me economists should invest more effort in figuring out how to minimise the impact of these devastating episodes in advance.

The question is whether real prevention is possible, given Mr Minsky’s insight about human behaviour. The experience of the so-called “Great Moderation” suggests that any stabilisation target may ultimately prove self-defeating. Relatively stable nominal income growth coincided with soaring private indebtedness:

And greater financial risk-taking:

This was no mere coincidence. Between the mid-1980s and 2007, the volatilities of both consumer price inflation and real growth were at the lowest they had been in decades. This led to the false belief that the authorities could (or would) sustain the seemingly benign macro environment under any circumstances. The rational response was to borrow a lot more and save a lot less. Why provision for bad times by holding safe liquid assets? Similarly, the observed decline in income volatility made debt appear less risky for both borrowers and lenders.

Alan Greenspan has repeatedly argued that the equity and housing bubbles that occurred during his tenure as Fed chairman were testaments to his success in restraining and stabilising consumer price inflation. According to him, investors reacted rationally to the observed decline in macroeconomic volatility by reducing risk premiums. This naturally drove up asset prices and encouraged high levels of indebtedness. It may sound self-serving, but Mr Greenspan’s logic jibes nicely with Mr Minsky’s claim that observed stability can make future instability worse. It also accords with the latest research on asset pricing, which says that the level of expected earnings is much less important than the expected volatility of those earnings.

Thus, the success of Mr Greenspan and his colleagues around the world, which was widely heralded at the time, may have been destined to end in catastrophic failure. The existence of the debt did not literally cause the downturn (the consensus is that the proximate cause was a run on the shadow banking system), but it made a deep and sustained contraction far more likely. When asked, Mr Greenspan says that the only safeguard against bubbles is constant economic volatility—not exactly a helpful suggestion, although some have argued that the 1970s were not as bad as commonly remembered.

Regrettably, there is no obvious way out of this dilemma.* Most would agree that we want to maximise the level of real income while minimising its volatility. Central banks can play a constructive role, but, after more than a century, we still do not really know what that role should be.

*Mr Minsky had a range of solutions, including a job guarantee scheme and a government budget big enough to offset changes in private investment spending. None of these ideas, however, can be implemented by the central bank alone. Moreover, the existence of these guarantees could conceivably prove as counterproductive as any other stabilisation scheme.

**For those who are interested, this is my final substantive post for Free exchange. (I will be joining Bloomberg View in a few weeks as a columnist and editorial writer.) I am very grateful to the Marjorie Dean Financial Journalism Foundation for giving me with the opportunity to write for The Economist for the past six months. It was incredible to work with and learn so much from my extraordinary colleagues, especially R.A., G.I., and R.D.

"As to your question, I personally think that central bankers have an impossible task. No one really knows how the system works. Very smart people are struggling to understand what drives this incredibly complex economy and how they affect it in real time."

Sounds to me like the Austrians and especially Hayek were right all the time. Their predictions seem to be quite accurate and simple although much more based on common sense and historical experience.

Economics is a lot like Biology, Ecology and Psychology - you cannot model, stir and predict accurately because you are missing too many parameters of the dynamic system.

Unfortunately, central bankers and many mainstream economists pretend to know them, they pretend that economics is like maths and physics, they even use similar methodologies and approaches just to fail miserably.

I guess that the reason why this is still going on is of course political because politicians/rulers need some kind of ideological or even better (pseudo)scientific and utilitarian justification for injustice and too many ambitious people are ready to provide exactly that.

Funny how history does repeat itself in slightly altered forms - in the Middle Ages the Church and its ideology was giving the justification for (economic) injustice, in the 19. and 20. centuries this were various writers, philosophers, intellectuals and their ideologies, while today this are the cardinals of neoclassical economics and central banking.

It may sound self-serving, but Mr Greenspan’s logic jives nicely with Mr Minsky’s claim that observed stability can make future instability worse.
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Correct, but why?
Minsky said the introduction of risky new financial products and/or the expansion of risky financial products are some of the drivers.
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Greenspan didn't care about the growth in sub-prime loans, liar loans, or people using their homes as ATMs, else he would have done something to limit it.
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I think he blamed it on "a flaw."
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So if your boss ever catches you not doing your job, just say you found "a flaw."
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Best of luck on your future endevors.
Don't be a stranger, stop in as a member of the Peanut Gallery here and rattle our cages from time to time.
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NPWFTL
Regards

Distortions generated by the build-up of financial imbalances weighs on the business cycles and once we super-impose the financial cycle variables, we have the information gap created about the true nature of the potential output; the question that inflation rises when real output exceeds the potential output and vice versa could have further ramification when we impose the heuristic as has been attempted by the BIS paper 404 by Claudio Borio, et al, that financialization driven by the profit motive could actually destabilize the business cycle and that the credit boom and bust cannot be easily regulated by monetary policy as Greenspan claimed.

I'd add one aspect. Even where central banks can help in crisis-handling, that help itself creates pent-up political pressures, since they lack democratic legitimacy for their actions.

The german politician who referred to Mario Draghi as a "forger" (regarding the promised OMT program) in the media was in fact expressing a widespread fear. And I would assume that there are plenty of equivalents to him across the atlantic, talking about the crisis-handling there.

In fact, the US crisis-handling (although pretty successful, agreed) may have contributed to the budgetary gridlock in congress.

Thanks so much! You can keep up with me on twitter (@Matthew_C_Klein) if you use it.

As to your question, I personally think that central bankers have an impossible task. No one really knows how the system works. Very smart people are struggling to understand what drives this incredibly complex economy and how they affect it in real time. There is certainly room for improvement, but I'm skeptical that we will ever find some magic bullet. Yet despite the track record, we have still managed an impressive increase in our standard of living over the past 100+ years. So that is one reason for optimism, in spite of everything.

While I sometimes disagreed with some of your arguments, or thought that they missed the underlying reason, I have to admit that your posts surely were the most thought-provoking and original on Free Exchange.
Just for that: Thank you. It's sad to see you leave.
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As to this post, I would say that Minsky's theory is very similar to the Austrians, but he never explained the underlying reason of those cycles. He never foresaw the importance of the central banks' interest rates.
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Same thing for inflation. It should not be defined as CPI only. If you take into account asset prices inflation, the economic environment looked a lot less benign suddenly in the last 30 years.
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There are so many other things I could say, but I won't.
Instead, go enjoy your drinks with your colleagues! :)

You should have placed Federal Gov't Public Debt/GDP
or Total Federal Debt/GDP next to your chart of
US Total Private Debt as Share of GDP.
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We would then see that as the percentage in your graph fell,
the graphs I proposed has risen.
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Basically we are exchanging Private Debt for Gov't Debt.
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NPWFTL
Regards

That’s true only if the savers stash their savings under a mattress. If they put it in a bank, under normal circumstances the bank will loan it out so that one man’s savings becomes another man’s spending. And if the borrowers are businesses in the capital goods sector, we will have sustainable growth.

Well, if I had twitter I'd certainly follow your posts, but ....
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As to your answer, and so we shouldn't part on a totally agreeable note (how out of character that would be, for me anyway) - with you on your observations/assessments of policy-makers' capabilities. Problem is, those guys and gals and …s have continuously presented themselves as being absolutely certain of both their knowledge and their ability to deal flawlessly with any eventuality - this despite their miserable track records. They never acknowledge error (on their parts) or fallibility in any respect. Couple that with abundant evidence of conflicts of interest and two words emerge immediately from my twisted mind - fraud and corruption.
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Anyway, knock 'em dead in whatever your next endeavor may be - and for God sakes don't fret that you've condemned us all to an Ip in our collective Avent for an indefinite duration. (Wish I knew who the hell RD is so I could ....)

Haven't you heard? The banks were bailed out. Who cares about Minsky anymore? His "Moment" was a brief one.
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"Mr Greenspan’s logic jives nicely with Mr Minsky’s claim"
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I think you mean "jibes". Somehow, I just can't see Greenspan and Minsky out on the dance floor together, swingin' the jive to Cab Calloway's big band.
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You were a sudden appearance of a sensible voice. I was surprized. The Economist's loss, Bloomberg's gain.

Free banking does have some appeal. But should regular people have to pore over bank balance sheets when deciding where to keep their deposits? Plus there is the issue of exchange rates between different bank moneys. If you haven't already, you may want to read Gary Gorton's "Misunderstanding Financial Crises" to get a sense of why we got rid of that system.

As usual, correlation does not imply causation. It's possible that a financial crisis may lead to a protracted recession. It's also possible that both are caused by a third phenomenon. For the sake of argument, let us assume our political system is completely rotten. Our elected offices go to politicians who're best at gathering campaign money, while our regulatory apparatus is staffed by careerists heading for--or having returned through--the revolving doors. This hypothetical government not fails to retard the excesses in the financial sector, it actively promotes them. The consequence is a serious financial crisis. Now, in its aftermath, is it reasonable to believe this same government would adopt policies that facilitate rebalancing of the economy? Or will we more likely find our officials continuing to water the dummy magic beans?

The problem is not one of choosing just the right amount of tinkering according to some computer model.
It is one of enabling and cosseting well-connected corporations and mega-banks and the politically-motivated encouragement of home-ownership and the obsession with constant debasement of the currency and allowing the world to become awash with money to be leveraged up in unproductive speculation, hedged with endless derivatives and...
There's a parameter missing from the computer model. It's called 'willful blindness'. And I warn you: it's big!
If we hadn't had central banks over the past century we might not have had such a vast increase in our standard of living but it would not now be dropping like a stone, inequalities would be less marked and we might have avoided some nasty wars.

I agree that an economic historian would be the best pick for a Fed chairman! But I don't think ending regulatory capture is possible. The stakes are too high. It costs Goldman Sachs very little to bribe Congressmen to get their people in power positions. Congressmen sell their power very cheaply. But the rewards to G-S are tremendous.

The only way to stop regulatory capture is to take the power from Congress so they have nothing to sell.

There's also the matter of ignoring the deflationary tendencies of vastly-rising productivity due to the computerization of production and distribution systems. The "stability" reported by central authorities actually required a great deal of inflationary policy to counteract the natural deflation which should have resulted from technological progress.